Return of Risk Dooms the Dollar
By the end of the week the markets finally saw some calm as news about the sub-prime fiasco began to recede from the front pages. As we noted on Friday, “The announcement that Bank of China carried nearly 10 Billion dollars of exposure to asset-backed bonds on its books had little impact on trade, partly because the Chinese bank is well capitalized and partly because the marked is becoming somewhat inured to stories of MBS risk. Traders attention is now shifting to handicapping what effect the past two weeks of volatility in capital markets may produce on the real economy.”

To that end the US economic news was actually surprisingly good, though backward looking. Durable goods expanded by the biggest percentage amount since 2004 largely on the back of aircraft orders, while New Homes sales increased for the first time since April despite the much publicized problems in the housing sector. The New Homes Sales number was a bit deceptive as only the West saw a steep pick up in sales. Nevertheless, the latest economic data suggests that US economy continues to function and perform well even in the face of mounting problems in residential real estate.

Ironically enough, positive news for the US economy and US stock markets spelled doom for the greenback as risk appetite returned to the currency market and the buck followed its familiar path of strength against the yen and weakness against all other majors. Next week event risk remains relatively tame with only GDP revisions and Personal Income and Personal Spending number of note. Given that this is the last week of August with Labor Day coming up perhaps the markets will get a much needed rest from volatility.

Euro – Hike or No Hike?
The ECB sent out conflicting messages to the market this week first signaling on Wednesday that the September hike was on schedule only to send out a clarifying statement on Friday that the hike may be on hold if market conditions did not improve. Despite the confusion the euro was hardly dented as it made steady progress higher all week long. The main driver was the renewed appetitive for risk as carry trades came back in vogue and both EURJPY and EURCHF soared taking the euro along with them for the ride.

On the economic front the news from the Eurozone was generally quite good as New Industrial orders beat forecasts and Composite PMI for August remained well above the 50 boom/bust line. As we noted on Friday, “Clearly, the higher euro and the decline in US consumer demand is having some negative impact on EZ growth but overall the economic performance in the 13 member region continues to follow an expansionary path which should maintain a hawkish bias in ECB monetary policy for the time being.”
Next week the IFO survey will be the marquee event of the week with market participants anticipating a sharp contraction in the wake of recent market turbulence. Yet the industrial sector is far less affected by the volatility of the capital markets and therefore an upside surprise is not out of the realm of possibility. With most European traders spending their final days of summer on the beach, dealing desks next week may be at half staff which could create some whipsaw action in the pair.

Yen Loses Momentum as Carry Comes Back
On Thursday night carry came back with a vengeance as calming news from the sub-prime market and reluctance of BOJ to raise rates beyond the current 0.50% level revived demand for high yielding currencies across the board. We stated in our report that, “Yesterday’s announcement after the close of US equity trading that BoA purchased a 2 Billion dollar stake in Countrywide Mortgage alleviated trader’s fears that the country’s biggest mortgage originator was in danger of bankruptcy. Only a few days ago CFC was reduced to tapping it bank credit lines as the liquidity crisis reached its peak. The Countrywide news served as a critical catalyst in turning investor sentiment from risk avoidance to risk assumption. In the currency market this dynamic translated into strong gains for the carry trade which was further aided by the BOJ decision tonight to keep rates steady at 0.5% preserving the interest rate differential against G10 high yielding currencies.”

Yet although the BOJ decision was clearly affected by the recent market volatility Governor Fukui warned that “Distortions and the misallocation of resources could occur if interest rates are kept at levels inconsistent with the economy.'' His pointed rhetoric suggested that the Japanese central bank will be ready to resume tightening monetary policy next month if global financial markets remain calm.

Despite Governor Fukui’s assurances Japanese economic growth remains problematic. Yen traders will focus on Retail Trade and Household spending numbers for any discernable signs of rebound in consumer demand. Some evidence if a pick up would go a long way in boosting the chances of a hike. In the interim yen will continue to dominated by carry trade flows, although like in all other pairs trading next week may slow to an appreciable crawl.

British Pound Recoups Losses As Growth, Rate Outlook Improves
The British pound was relatively unencumbered by the economic calendar and volatile market conditions last week, allowing the currency to win back some of the losses it had incurred through the wave of global risk aversion that overcame the markets over the first half of August. Looking at the economic docket from this past period, there was little threatening to unnerve traders who were still focused on yen crosses and equity activity for guidance on their own risk tolerance. However, there were a few indicators that crossed most fundamental traders’ radars. Over the first few days, lending and inflation took center stage. Housing price pressures through August, measured by the leading Rightmove report, accelerated modestly to 12.8 percent. Less objective in its report on inflation was the M4 money supply and lending figures for July. The rate hike last month obviously had a direct impact on public sector borrowing which dropped 6.5 billion pounds, yet the money supply actually accelerated slightly to a 13 percent rate. The more glossy market moving fodder came on line Friday morning in the second measurement of growth. The headline figures were untouched, a 0.8 percent rate of expansion for the quarter and 3.0 percent for the year. The data was not totally unscathed though; the breakdown reported a few surprising results. A pick up in consumer and government spending to the tune of 0.8 percent was strong enough to offset a surprise 1.1 percent drop in capital investment and a 1.0 percent drop in exports. Looking back over the path of the sterling last week, it would be imprudent to ignore the impact that general risk flows had on price action. Sharp drawdowns in all pairs considered in any way, shape or form overbought or otherwise related to the carry trade were on the rebound in a global effort by central banks to inject liquidity into financial hubs. The turn was made official when the Fed announced it had cut its discount rate.

Interestingly enough, though the Fed, ECB and BoJ continued to shore up liquidity last week, the Bank of England held out as the only central bank not to flood its domestic markets with cash. The only activity on the board was a loan to Barclays Plc on the 21st of 314 million pounds at the emergency 6.75 percent – the first in a month after the subprime rout began in earnest – which seemed suspicious, though officials assured it was related to a delayed loan from HSBC and nothing else. So what does the MPC’s resolute stance convey? Perhaps this is a sign that they still want to hike or they are confident that as the world’s financial center they could weather the globe’s problems. However, both seem dangerous propositions given the UK’s housing market is at dangerous heights in its own right – a problem made worse by record consumer debt. The docket next week is yet another light one. The GfK confidence survey will be the pinnacle of the week.

Swiss Franc Falls Back On Data As Carry Traders Lose Interest
Though it is the number two funding currency in the carry trader’s toolbox, the Swiss franc has struggled to win back lost ground at the same clip that the Japanese yen has. Perhaps the franc’s title as a reserve currency was muddling the rebound in risk appetite. In financial markets around the world, equity benchmarks were turning higher, government bond yields were reversing course after touching multi-month lows, credit spreads on the corporate and money market level were once again contracting to normal levels and premiere carry trade pairs (like the yen crosses) were retracing portions of their massive losses from the opening weeks of August. And, all the while, USDCHF spent most of the period in a 100 point range. One handicap for the Swiss currency was that it received funds not only as a carry unwind but also as investors sought safe havens for their capital. As traders started to move their money back into so-called ‘risky positions,’ both the dollar and franc were on the chopping block. Another explanation for the unit’s inability to capitalize on risk trends was the activity on the economic calendar. Reports on import and producer inflation, international trade and investor confidence all fell through the week. The saving grace for the docket was the quarterly employment data, which coincidently provided the most impressive surprise on the period’s top indicator. Employment over the three months grew 2.4 percent (the most in seven years) to 3.737 million (the highest level on records going back to 1991). This fills in the gap for areas of disappointment for the week as strong domestic consumption will make up for the trade imbalance and encourage firms to pass on costs for more expensive raw materials even as imported inflation eases.

This coming week will be another one that is laden with economic data. The fundamental action opens early with UBS’s proprietary consumption indicator. The spending report precedes the retail sales report, and gives a broader look into spending habits beyond the confines of just the retail sector; so its economic influence is high even if its impact on price action isn’t. On the following day, the KOF leading economic indicators index will give the monthly update on growth forecasts. Economists are calling for a marginal improvement for April; though once again traders may reserve their growth trades until the following week when the government reports second quarter GDP. Finally, the consumer inflation report will wrap things up in a decidedly anti-climactic close. Though the SNB frequently quotes possible future price pressures when it gathers for its quarterly rate hike, front-line price pressures have held well below the central bank’s target level. The market has long picked up on this dichotomy; so a reaction from USDCHF will likely be limited. Finally, outside of the tidy calendar, an eye should be kept on risk developments at all times. Though the franc has not responded in the recent wave of risk capital flows, that does not bar a carry move from overwhelming safe haven considerations and driving the Swiss into a steep pitch.

Canadian Dollar Could Gain Despite GDP Slowdown
The Canadian dollar ended the week higher against the greenback, as the US currency’s weakness gave USDCAD bears hope for a return to the recent 30-year lows. Economic data from the country was broadly mixed, as retail sales were worse than expected, showing a sharp drop of 0.9 percent - the sharpest decline since September 2006 - as auto sales plummeted 2.7 percent while receipts at gasoline stations fell 2.5 percent. Excluding autos, retail sales fared a little better, but still slowed significantly from May's breakneck pace at a rate of -0.3 percent. Nevertheless, May's gain helped retailers record their best quarter in almost six years, as sales rose 3 percent during the second quarter - the best reading since the fourth quarter of 2001. Meanwhile, CPI for the month of July was released exactly in line with expectations, and for the Bank of Canada's monetary policy group, this marks the fifth consecutive month that consumer inflation has grown faster than the established 2.0 percent target as the annualized measure holds at 2.3 percent. Nevertheless, with the local (and global) economy threatened by growing credit problems, a rate hike on these numbers seems doubtful.

Looking ahead, Canadian economic data may not bode well for the national currency, as Q2 GDP is anticipated to slow sharply to 2.8 percent from the year prior. Given the rapid appreciation of the Canadian dollar throughout the quarter, demand for products from the country likely took a hit. In fact, exports slid 1 percent to C$39.3 billion in June on lower sales of machinery and equipment such as aircraft. On the other hand, as we mentioned above, retail sales proved to be net positive during the second quarter, signaling that consumption should make a positive contribution to GDP report. While this economic data is certainly important to keep in mind for the Loonie, the currency has not been trading based off of fundamentals lately. In fact, technical levels and a monthly trading anomaly favor a move to the downside (for more on why, click here for David Rodriguez’s special report). As a result, traders may find USDCAD down near the 1.0400 by the end of this week, even if economic data prove to be disappointing.

Will Australian Data Help Further AUD/USD Gains?
The Australian dollar rocketed higher throughout last week, racking up nearly 300 points to test the 0.8274 level, and while economic data worked in favor of the currency, it was the resurgence of carry trades that really gave AUDUSD a lift. Liquidity crunch jitters started to calm in the equity markets, and the effects were felt throughout the forex markets as traders felt more confident taking on leveraged bets. Looking at the fundamental data on hand, the Westpac leading index jumped 1.0 percent during the month of June as dwelling approvals advanced 7.5 percent and real money supply expanded 2.2 percent from May. Furthermore, with the jobless rate at a 33-year low of 4.3 percent and rising wages prompting consumers to spend more, and growing sales of commodities to China driving export earnings and business investment, economic expansion in Australia looks likely to continue. Finally, given the slower tightening pace that the Reserve Bank of Australia has taken over the past year versus central banks like the Reserve Bank of New Zealand, there are far fewer roadblocks for growth.

This week there is a significant amount of data due to be released, but the most important market-movers come at the latter end, as retail sales and the trade balance will both hit the tape. Retail sales growth is anticipated to slow to 0.6 percent in July, down from 1.4 percent during the month prior. While this may not be incredibly bullish for the Australian dollar in the near-term, consumption still remains strong and should be a driver of GDP growth during the third quarter. Meanwhile, the trade deficit is predicted to narrow in July, as export demand remains hot. Looking at technical levels for AUDUSD, 0.8274 may hold up as solid resistance, but a continuance of the bullish momentum and a break higher could take on 0.8414. On the other hand, a return to risk aversion throughout the markets would take the pair back down to 0.8120.

Carry Trade Rebound Jumpstarts Kiwi, Can It Continue
The New Zealand dollar has shown an impressive rebound from last week’s dismal performance, as a slow return to risk appetite has led the high-yielder higher against major counterparts. Carry trade interest was clearly the main source of NZD bids, as the Japanese Yen shed a similarly significant portion of its recent gains. Indeed, the Kiwi rallied despite headwinds from largely disappointing economic data. The domestic economy showed a much larger than expected trade deficit through the month of July at a -791 million gap between Imports and Exports. External demand for New Zealand production continued to drop on the exceedingly high NZ$ exchange rate, while domestic demand for foreign goods was boosted by the relative drop in prices for imports. Yet markets tempered their reaction on the disappointment; given a substantial decline in the New Zealand dollar, such negative effects on overall trade will likely improve over the long term. Speculators likewise ignored disappointments in Credit Card Spending and Services PMI. The trend remains towards slowing domestic economic growth, but some analysts nonetheless feel that the central bank may continue to raise interest rates on the inflationary tumbles in the NZ$.

Upcoming economic data will be relatively limited, with the seldom market-moving Money Supply figures and NBNZ Confidence number due towards the end of the week. The wild card remains the announcement date for Producer Price numbers, which are scheduled for release anytime between the 26th and 30th of the month. Though these are the producer price inflation numbers for the second quarter, they will nonetheless influence expectations for the Reserve Bank of New Zealand’s policy setting meeting on August 12. Analysts unanimously expect the bank to leave rates unchanged, but markets will listen very closely to attached statements by RBNZ Governor Alan Bollard. Despite slowing signs of economic expansion, some feel that the bank remains on the offensive on weakness in the exchange rate. Given that the RBNZ has a fixed inflation target, Bollard may have little choice but to raise rates in the face of highly inflationary import prices. Time will tell if the central bank continues tightening monetary policy. Higher rates may not necessarily be bullish for the Kiwi if risk aversion returns, however, leaving the performance of risky financial asset classes critical to the outlook on the Asia Pacific currency.

Boris Schlossberg is a Senior Currency Strategist at FXCM.